I'm a private money manager and freelance writer focused on Peak Oil and Climate Change as investment themes. I manage portfolios for individual clients and am co-manager of the JPS Green Economy Fund, a hedge fund open to accredited investors looking for exposure to Peak Oil and Climate related themes. I no longer write for Forbes, but I'm Editor at AltEnergyStocks.com, where I've been analyzing clean energy stocks since 2007. I live in Upstate New York, and am a runner and a woodworker. Since I write for several sites, you can follow me on Twitter, where I tweet new articles and links to other things that catch my eye on the web. DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This blog contains the current opinions of the author and such opinions are subject to change without notice. Blog entries are distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

The End Of Elastic Oil

The last ten years have brought a structural change to the world oil market, with changes in demand increasingly playing a role in maintaining the supply/demand balance. These changes will come at an increasingly onerous cost to our economy unless we take steps to make our demand for oil more flexible.

We’re not running out of oil. There’s still plenty of oil still in the ground. Oil which was previously too expensive to exploit becomes economic with a rising oil price. To the uncritical observer, it might seem as if there is nothing to worry about in the oil market.

Unfortunately, there is something to worry about, at least if we want a healthy economy. The new oil reserves we’re now exploiting are not only more expensive to develop, but they also take much longer between the time the first well is drilled and the when the first oil is produced. That means it takes longer for oil supply to respond to changes in price.

In economic terms, the oil supply is becoming less elastic as new oil supplies come increasingly from unconventional oil. Elasticity is the term economists use to describe how much supply or demand responds to changes in price. If a small change in price produces a large change in demand, demand is said to be elastic. If a large change in price produces a small change in supply, then supply is said to be inelastic.

Elasticity of Demand

On the demand side, the elasticity of our demand for oil reflects the options we have to using oil for our daily needs. At a personal level, we can quickly cut our demand for oil a little bit by combining car trips, keeping our tires properly inflated, etc. But the ability to make such reductions is often limited, and even such simple measures come at a cost of time or convenience, which is why we’re not doing them already. If we live in an area without good public transport (as most of us do) we can’t stop driving to work without losing our job, so we keep driving to work, and paying more for the gas to get there.

Over the longer term, our personal options to cut oil consumption increase. We can move closer to work, or to somewhere where we can walk or use public transport to get to our job. This is why the most fuel-efficient vehicle is a moving van.

Replacing a car with a more fuel efficient vehicle is an option for those who have money or credit, but the people who are under the most pressure from high fuel prices are unlikely to be able to afford such options. If they can’t resort to ride sharing or public transport, they may simply lose their jobs because they can’t afford to get there.

The reduction in fuel use that comes from people losing their jobs and no longer commuting to work also contributes to the elasticity of demand, and I mention it to highlight the point that while reductions in fuel use can be benign (properly inflated tires, for instance), they can also be harmful to the economy. Reductions in demand due to high prices are often called demand destruction, and it’s just as unpleasant as it sounds.

Elasticity of Supply

Since our options for reducing oil demand in response to rising prices range from inconvenient to expensive, to downright painful, it’s clear why the media and politicians focus so much attention on the other half of the equation: When supply adapts to changes in demand, voters don’t have to make uncomfortable choices.

But there are also limits to the ability of oil supply to adjust. Most OPEC nations, including Saudi Arabia, need at least a $100/bbl for oil to keep their budgets in balance, so why would they increase production to reduce the price below that? In fact, as (subsidized and hence inelastic) OPEC domestic consumption continues to increase faster than supply, OPEC net exports will continue to fall, further raising the price needed to balance exporters’ budgets.

While fiscal issues constrain OPEC’s elasticity of supply, geology and politics constrain oil supply elsewhere. Brazil’s giant pre-salt fields, like deep water discoveries in the Gulf of Mexico and elsewhere, are much more expensive and slow to develop than were past discoveries. Canada’s tar sands are large mining operations, and are similarly slow and expensive to develop.

Put simply, if the oil were quick and easy to get at, we’d have gotten it already. All these factors mean that the elasticity of oil supply is falling, so oil demand has to adjust more in response to changes in price than in the past.

Data

Since there is little reason to assume that the elasticity of oil demand has changed significantly (do we have more options for doing without oil than we did ten or twenty years ago?) while the elasticity of oil supply has fallen, we have to expect that overall oil price elasticity has fallen as well, and these changes should show up in oil market data.

Using oil annual supply, price and consumption data from the EIA and IEA, and making some back-of the envelope adjustments to account for the difference between their different definitions of what constitutes oil, I made some estimates of the price elasticity of oil supply and demand.

Since neither demand nor supply can respond instantly to changes in price, I first had to estimate the average reaction time. To do this, I looked at the correlation between changes in the oil price and changes in supply and demand with various lags. I used price and volume changes over a period of three years because three year changes gave me the strongest results, although one and two year changes were similar.

Below you can see the correlations between three year changes US and worldwide supply and demand with three year changes in US oil prices (WTI) and world oil prices (Brent), after various lags:

Note that we’re looking for negative correlation between price and demand (we use less oil when we have to pay more for it), and positive correlation between price and supply (companies produce more oil if they can get more money for it.)

From the chart, we can see that world oil supply has historically taken about one year to respond to changes in world prices (the blue line peaks at 40% correlation with a one year lag), while domestic US oil production (supply) has typically taken about four years to respond to changes in the oil price, but that response is much stronger than the response of world supply.

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Enjoyed the analysis. One obvious solution is the use of natural gas for the heavy truck and fleet transportation sector. An attractive solution for urban areas with air quality issues and as diesel prices continue to rise, it is economic to convert. Should be included alongside electric vehicles as batteries cannot power Class 8 trucks as of yet. Produces lots of jobs as well in infrastructure development, improves our trade deficit and national security profile.

Hudson, I agree that LNG trucking is also a useful option, but I don’t feel it needs any more emphasis than it already has- shifting freight to the rail network is more effective, and while natural gas prices are currently low, they are unlikely to stay that way. Given that there are efforts to export LNG, any more LNG we use domestically is not going to do much to improve our deficit, since it will cut into LNG exports. Much better to just reduce fuel use overall by shifting to rail.

More efficient trucks, however, are a win-win-win, since they are more economical, improve our trade balance, and reduce pollution.

Diesel/electric railroad locomotives are already hybrids. They have been for over 70 years.

The diesel motors drive generators that provide electricity for power. This provides smooth, easily controlled power that can be easily reversed without the need for heavy and mechanically complicated transmission gearing.

Conventional locomotives could be easily and inexpensively adapted to use electrical input directly from(for instance) overhead lines, in which case, the diesel engines would not be needed. This has already been done for years in Switzerland and various switch yards in cities were air pollution is a problem.

Diesel engines can also be made bi-fuel or dual fuel to run on gaseous methane in combination with, or without the need for petroleum fuel. Rolling stock tank cars are already used to transport gases and converting a tank car to carry either gaseous methane or LNG would be a simple matter—-just install a valve and line to the locomotive.

CNG as an option for light duty vehicles has been around for a long time. Any internal combustion engine can be converted to run on CNG(relatively easy for Otto cycle engines, standard gasoline/CNG bi-fuel). Worldwide, there are about 14 million CNG vehicles on the road, mostly in Europe, South America and Asia.

The largest single use of natural gas currently(in the US) is heating buildings and water. Solar energy is low tech, low cost and easy to manufacture, install and maintain, close to 100% efficient—and the fuel is free. Solar thermal is also ideally suited as an add on, auxiliary system to an existing system. Your furnace or water heater would function exactly as it always has, coming on and off in response to the thermostat settings you provide. The difference is, your furnace or water heater would come on far less often and run much shorter time periods when it does, if at all. You’d use a lot less energy.

If you have a vehicle that is bi-fuel and can use natural gas—-take the energy that you did not use to power your furnace and water heater—-and put it in your vehicle. You would, in effect, be running your vehicle on free solar energy. It takes energy to heat water. A LOT of energy. Since water heaters usually run 24/7, and people only use their vehicles only intermittently—-on average, you’ll have more natural gas available to run your vehicle than you actually use.

Natural gas is CH4. 80% hydrogen by molar volume. To produce the same amount of energy using CH4 compared to petroleum, CH4 produces only about 65% of the CO2 that petroleum does.

If all of our vehicles were running on natural gas—doing the same things we do right now, the CO2 produced would be the equivalent of taking every third vehicle off of the road permanently. And the equivalent in total pollution emitted to removing more than 90 out of 100 vehicles off the road permanently.

CH4 offers many advantages over petroleum. It is cheap, abundant, and clean. It can be used for any application that we need done. We do not need to import methane, and we do not need to fight wars over methane.

And we do not need to worry about ever running out. We can make CH4, low tech, inexpensively and easily from any type of biomass at all, including sewage and landfills. We’ve been able to do it for over 160 years, and it is being done right now. Germany is on track to be producing 20% of their methane usage from biomass by 2015—-5 years ahead of the original goal of 2020.

Pmagn- While the accepted wisdom is that everything is about Energy Return on Energy Invested, I tend to disagree. If the energy is converted into a higher quality in the process (and liquid fuels are a very high quality energy), then society can survive EROEI <1 for some purposes, so long as the energy invested than the energy returned. Examples include electricity generation from coal and natural gas, which have EROEI of about 0.3 to 0.6.

I agree that as EROEI for oil falls, we’re going to have to make oil a lot less central to our economy, but using less of it in all the industries you mention. Which I guess is just another way of saying the same thing you are. We can’t have EROI fall near or below 1 without drastically changing how our economy works, and unless we plan ahead and start the changes now, the transition will be a very painful one.

Electrify and expand the frieght rail system, end the annual $30 to $40 billion subsidy to trucking (they cause much more damage than they pay for).

20 BTUS of diesel become 1 BTU of electricity when frieght moves from truck to electrified double stack train.

Another is build Urban Rail as fast as efficienctly as the French are doing (1,500 km of new tram lines (Light Rail) in every town of 110,000 2010-2020 for 22 billion euros, double Paris Metro, 2 million new passengers, 200 km of new subway, 2013-2025 20.5 billion euros).

And make bicycling safer and easier. Portland wants 25% of urban trips by bike in 2030 and will spend $600 million to make it possible. Copenhagen started earlier and will be 50% of urban trips by bike in 2015.

Thanks for doing this analysis, Tom. However, it does seem to me that you’re leaving out the elephant in the room, which is that the structural change is much deeper than you suggest.

We know from the UK Industry Task Force on Peak Oil (Arup, Virgin and others) , which uses one of the world’s oil megaproject databases as its basis, that there are insufficient oil projects currently under construction to meet the annual decline rate of 4 million barrels per day per year — as you point out, new projects are taking too long to be completed as the oil they target moves to more difficult locations (offshore, deeper, etc.).

So let’s say we’re at the peak of production, which seems very very likely since now even the International Energy Agency says the peak of conventional production was 2006 (and Nature recently published a study showing it was 2005). How fast does it decline?

For that, the best estimates seem to come from the Uppsala Global Energy Systems Group and their best case scenario puts it at 2% per year, which is roughly how fast production increased, on average, since 1970. That may not sound like much but it’s enormous: after 10 years it is (1 – (0.98 ^ 10)) = 18.3% less oil. If anyone thinks that isn’t a lot of oil to lose in ten years, they really don’t understand the situation.

But it’s actually worse than that because the decline will not be shared proportionally. The oil producing countries export only the oil they don’t use themselves and they use roughly half the world production. So what we saw in country after country (like Indonesia, for instance) as they reached their peak is that domestic supply is held steady and exports are reduced. In other words, the 18.3% is entirely going to come out of the half of production purchased by oil importing countries like the U.S.

Shrink the pie by half and 18.3% is now double that.

There is no way to avoid a massive economic shock with what is facing us. Remove that much oil from the world economy that quickly and we will not be able to respond in time. Debts will not be repaid, banks and countries will become insolvent and governments will have difficulty providing services as their tax revenues shrink.